How Falling Exchange Rates 2000-2007 Have Affected the U.S. Economy and Trade Deficit (Evaluated Using the Federal Reserve's G-10 Exchange Rate)

Abstract

Falling exchange rates reduce the purchasing power of the dollar, increasing import prices. Higher import prices have two effects. (1) A substitution effect that shifts demand from imported to domestically produced goods. (2) An income effect that reduces the total amount of real income available for spending on domestic goods and foreign goods. Based on U.S. 1960 - 2000 data, this paper estimates an econometric model that finds that the income effects of falling exchange rates overwhelms the substitution effects, causing a net negative influence on the GDP and income. Results indicate demand for both imported and domestic consumer and investment goods is adversely affected because the income effect is so dominant.. For investment goods, there was virtually no substitution effect out of imported goods when import prices rose due to a falling exchange rate. Declining real income also caused decreased demand for domestically produced investment goods. For consumer goods, the substitution effect stimulated domestic demand, but was more than offset by the negative effect of declining income. The decrease in demand for domestic goods and services was 3.6 times as large as the decrease in demand for imports. Therefore, the trade deficit fell far less in dollars than the GDP. The study estimates that, other things equal, the trade deficit would fall from 4.3% to 2.1% of the GDP as a result of a large twenty percent weakening of the dollar, such as occurred 2000-07. Had the exchange rate not fallen during this period, we estimate the average annual growth rate of the U.S. economy would have been 3.7%, not the 2.7% it has actually averaged, assuming sufficient capital and labor availability to do so. Finally, we find that a falling trade deficit induced by falling exchange rates, reduces the size of the annual transfer of U.S. assets to foreigners needed to finance the deficit, but does not result in a faster rate of net growth for U.S. assets, because declining income also reduces domestic savings by a comparable amount.